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Acquisitions among New York Stock Exchange specialist firms can increase specialist firm size, capitalization, and market concentration, and thereby affect the market quality of the stocks they trade. We find that while traded stocks show significant improvement in several market quality measures following acquisitions, similar changes are evident in matched control stocks not involved in acquisitions. We conclude that specialist firm acquisitions either do not improve market quality, or improve market quality, but competitive and other pressures (resulting partly from the acquisitions themselves) force improvements in market quality for control stocks also. Either interpretation implies that specialist acquisitions have not had deleterious effects on market quality.

Acquisitions among New York Stock Exchange (NYSE) specialist firms have changed the structure of the U.S. listed-equity business dramatically over the last several decades. Stoll (1985) reports a reduction in the number of NYSE specialist firms from 230 in 1933 to 59 in 1983. The Wall Street Journal (July 2, 1992) reports that an additional 21 specialist firms were acquired between the October 1987 stock market crash and June 1992. This reduction has continued, leaving only eight NYSE specialist units in December 2001. David Humphreville, director of the NYSE Specialists Association, speculated that further consolidation to three or four specialist units would still be “workable” at the exchange (Traders Magazine, February 1, 2000). Consolidation among specialist firms is not unique to the NYSE. Following the multiple listing of blue-chip options in August 1999 and the ensuing competition among option market specialist firms, spreads and specialist firm profits have fallen in these markets.1 Financial press reports indicate that as a result “most, if not all, small- to medium-sized specialist firms are interested in selling their businesses to major trading firms” (Dow Jones News Service, July 5, 2000). Decimalization in equity and option markets also hastens consolidation via pressure on spreads and market-making profits (see e.g., Chakravarty et al., 2001). An official of a large market-making firm claims that tighter spreads on Nasdaq resulting from decimalization “will mean the mid-level market makers will be in trouble” (Traders Magazine, January 1, 2001). As with acquisitions in any industry, the effects on consumers can be positive, negative, or zero. Specialist firm acquisitions potentially result in larger, better-capitalized, and better-diversified specialist units that are less risk-averse and better able to exploit scale economies and technological improvements. Theoretical and empirical analyses in the microstructure literature imply that these changes can both reduce the inventory management and order processing costs specialists face and improve their ability to provide price stability and increased depth. In a competitive market, specialist firms would pass on cost savings and other improvements in market quality to consumers. Throughout the paper, we adopt the perspective of liquidity demanders when we discuss changes in market quality for consumers or investors. Of course, improvements in market quality for liquidity demanders (e.g., tighter spreads and greater depth) can make competing liquidity suppliers (e.g., limit-order traders and institutional investors) worse off. Conversely, specialist firm acquisitions can potentially increase specialist firm market power and reduce competition to a degree that allows them to increase their economic profits by increasing trading costs or reducing other dimensions of market quality. Acquisitions can also result in a stock being traded by a new specialist employee lacking expertise in detecting informed order flow for that stock. Thereby adverse selection costs can increase. Adverse selection costs can also increase if acquisitions increase ownership diffusion, which weakens incentives to detect informed order flow (Coughenour and Deli, 2002). Another potential negative effect of specialist firm acquisitions is increased systemic risk, in which the failure of a large specialist firm could have harmful market-wide effects. Citing concerns about systemic risk, the NYSE increased specialist capital requirements effective October 30, 2000 and made the requirement an increasing function of the specialist firm's market share (see SEC Release No. 34-42417). Through these positive and negative effects, specialist acquisitions can affect overall market efficiency. Thus, specialist firm acquisitions are an important public policy issue. Informed decision-making by specialist firms, exchanges, and regulators about future acquisitions requires knowledge of their costs and benefits. In this paper, we attempt to begin providing such information. We examine the impact on several dimensions of market quality of a sample of acquisitions of NYSE specialist firms occurring between 1994 and 1998. We estimate changes in dealer and adverse selection costs and effective trading costs using Madhavan et al.'s (1997) model of the bid–ask spread. The dealer-cost component comprises order processing and inventory management costs plus dealer profits. For robustness, we also examine measures of realized spread, price impact, and effective spread (see Huang and Stoll, 1996; Bessembinder and Kaufman, 1997). We also investigate other dimensions of market quality such as quoted depths, price stability, price continuity, and specialist participation. Although acquisitions can increase systemic risk, we know of no effective way to measure this risk or its cost. We find several statistically and economically significant changes in market quality measures for both target and acquirer stocks following the acquisitions. In general, trading costs, price stability, and specialist participation measures show significant pre- to post-acquisition changes that are consistent with the combined specialist unit providing improved market quality. While several of the changes are consistent with theoretical arguments relating specialist firm size, diversification, capitalization, and operational efficiency to various dimensions of market quality, we generally find changes of approximately the same magnitude for samples of control stocks matched on price, volume, market capitalization, and return volatility, and traded by specialist firms not engaged in acquisitions. Thus, we cannot unambiguously attribute to specialist acquisitions the changes in market quality that we document. Rather, the changes that we observe may reflect changes in overall market quality over time. Consistent with this possibility, Chordia et al. (2001) document a downward trend in quoted and effective bid–ask spreads for a broad sample of NYSE stocks over the 1988–1998 period, which includes our sample period. One possible conclusion from our results is that specialist firm acquisitions do not result in more efficient specialist units and do not impact market quality. Importantly, however, our results do not necessarily imply this conclusion. Interpreting results from the control sample is complicated in this study because the changes we observe for control stocks could be in response to the same stimuli that lead our subject firms to engage in acquisitions, and even in response to the acquisitions themselves. Press reports imply that specialist firms merge, at least in part, in response to increased pressures created by volatility and capital requirements and by the need for improved technologies and more efficient scale. NYSE specialist firms also face increased competitive pressures from regional exchanges and third market broker-dealers (see Arnold et al., 1999; Battalio et al., 1997). Both subjects and controls likely face these increased pressures, which lead to reductions in trading costs (see Demsetz, 1968; Tinic, 1972; Tinic and West, 1972). Subject and control firms should show differences in their respective changes in market quality measures only if the controls do not or are unable to respond to the same competitive and other pressures that subjects do. There are at least two ways besides acquisitions, however, that control firms could respond. First, if the market for dealer services in NYSE-listed stocks is less than perfectly competitive, control firms could respond to increased pressures by reducing their monopoly rents even if their own cost structures do not change. Second, sufficiently large control firms could employ new technologies and take other actions that reduce their costs. Consistent with this second possibility, we find that it is primarily small specialist firms that exit the industry as targets in acquisitions. The remaining nonacquiring firms from which our control stocks are drawn are larger on average than the exiting target firms. Under the alternative conclusion that control firms respond to the very same stimuli motivating the acquisitions and possibly to pressures stemming from the acquisitions themselves, we can infer that specialist firm acquisitions have positive effects on market quality as long as the increased concentration does not weaken competition and capital requirements keep systemic risk at acceptable levels. Regardless of which interpretation of the results we take, we can safely conclude that specialist firm acquisitions have not had deleterious effects on market quality. Specialist firm acquisitions do not appear to generate adverse changes in trading costs, depth, price stability, or other measures of market quality for investors demanding liquidity. Our results have implications for how specialist firms, exchanges, regulators, and researchers view future acquisition activity among specialist firms. Section 2 reviews extant theoretical and empirical work to help understand potential effects of specialist firm acquisitions on market quality. Section 3 describes our data set and methods. Section 4 presents results and Section 5 concludes.

We examine the impact of specialist firm acquisitions on market quality. The stated motivations for these acquisitions and implications from theoretical models of the spread indicate that market quality should improve as a result of these combinations. Stocks traded by both acquiring specialist firms and target firms show several significant improvements in trading costs and market quality measures. But in general these changes do not differ from those for samples of control stocks matched on price, volume, market capitalization, and return volatility. While specialist firm acquisitions can lead to increases in specialist firm capitalization, diversification, and size, and increases in market concentration, we cannot uniquely attribute the positive changes in market quality to the acquisitions because control stocks generally show similar changes. Our results have two possible interpretations. First, we could conclude that specialist firm acquisitions have no significant effects on market quality. Second, we could conclude that competitive, regulatory, and other pressures are forcing specialist firms to improve market quality, and that all specialist firms are finding ways to respond to these pressures. Some firms could choose acquisitions and some could choose other approaches, with all approaches leading to improvements in market quality. When an entire industry faces and responds to pressures in multiple ways, it is difficult for researchers to distinguish empirically between the two interpretations. We leave this question about NYSE specialists for future research. Without answering that question, we can still safely conclude that specialist firm acquisitions have not had any measurable deleterious affects on market quality for investors demanding liquidity. We should emphasize, however, that NYSE specialist firms continue to merge and that past some threshold level of concentration, the negative effects of increased market power could dominate any positive effects from acquisition-related efficiencies. Buttressing concerns about this possibility, Christie and Schultz (1994) find evidence suggesting implicit collusion among NASDAQ market makers, even in stocks with relatively larger numbers of market makers. Our evidence is consistent with the view that vigorous competition among limitorder traders, third-market broker–dealers, regional exchanges, and NYSE floor traders and specialists has reduced execution costs in NYSE-listed equities. One element of effective competition by off-exchange entities is fragmentation of NYSElisted order flow. While many market professionals and regulators express concern about the negative consequences of fragmentation, (which has increased over our analysis period), our finding of reduced execution costs for subject and control stocks implies these concerns are overstated. While we find no measures of trading costs or stockand order flow characteristics that allow us to predict reliably which specialist firms are acquirers and which are targets, we recognize that the decision to acquire a target specialist firm is endogenous. It could be that poorly managed or inefficient specialist firms are the primary targets in acquisitions and larger more efficient firms acquire them and then reduce the combined firms’ costs. Alternatively, specialist firms could be attractive targets in acquisitions because they are especially profitable. If competition does not force the merged firms to share cost reductions or abnormally high profits with investors, we would not observe reductions in the spread-based measures we examine. Thus, we cannot rule out the possibility that specialist firm acquisitions occur because they provide the merging firms with significant benefits, but that limited competition means the merging firms retain these benefits. This limitation does not affect our general conclusion that specialist firm acquisitions have not had deleterious effects on market quality.